The Economics of Innovation Procurement

Transcription

1 The Economics of Innovation Procurement 2nd SEREN3 Training for stakeholders on PCP/PPI in Secure Societies 30th of May 2017, Warsaw, Poland Dr. Anne Rainville Management Consultant, Vtrek Julianaplein 21, 5211 BB 's-hertogenbosch The Netherlands +31 (0)

2 Outline Introduction to procurement economics Innovation procurement Pre-commercial Procurement (PCP) Public Procurement of Innovative Solutions (PPI) Introduction to the Business Case Methodology Economic evaluation theory and practice Uncertainty - Justifying PCP Time - Discounting, Net Present Value, Returns The stand-alone PPI Reaping rewards Royalty Schemes Discussion

3 What is Procurement Economics Public Procurement is ~18% of European GDP To support demand-side innovation Demand-pull vs supply-push To help procurers achieve: Primary goals service improvement, cost reduction Secondary goals innovation, sustainability To support rational and transparent decision-making Building a business case Gaining internal project support

4 Pre-Commercial Procurement (PCP) Develop and test new solutions through R&D to meet the challenge identified Purchase R&D to Steer the development of solutions to procurers needs Gather knowledge on pros/cons of alternative solutions Support a competitive supply base (avoid later lock-in) Purchase R&D from several suppliers in parallel (comparing alternative solution approaches) Closed competition and evaluating progress after critical milestones (design, prototyping, testing) (IPR-related) Risks and benefits of R&D are shared between procurer and suppliers - Maximizes incentives for wide commercialization

5 Phases of PCP

6 Public Procurement of Innovative Solutions (PPI) Incremental innovation or scaling up to meet the identified challenge No R&D takes place is already completed, or not required to solve the challenge When a solution is Near to the market Already on the market, but in small quantities Procurer acts as launching customer / early adopter / first buyer

7 Innovation procurement

8 Phases of a PPI 1. Announce intention to buy a critical mass of innovative solutions triggers industry to bring products to the market With a desired price : quality ratio Within a specific time 2. Verify whether what market delivers the desired quality/price e.g. via a test and/or certification 3. Purchase a significant volume of innovative solutions.

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10 Business Case Methodology To help public procurers engage in innovation procurement by reducing risks and identifying incentives By identifying the procurer s need for innovation and private actors abilities to meet this need Six steps: 1. Needs identification and assessment; 2. Prior art analysis and intellectual property rights (IPR) search; 3. Analysis of the standards landscape; 4. Economic calculations; and 5. Open market consultation Procurers can directly apply the methodology during the preparatory phase

11 An ICT hardware solution? - The Case Study There are currently 100 units of an ICT technology The technology is non-functioning 5% of the time Repair costs are 27,50/hour, and repair takes 9 hours Total monthly cost: 27,50/hour x 9 hours x 100 units = /month A procurer wants to reduce the down-time by half Potential monthly savings: /month 2 = /month The procurer estimates the price of the solution (all units) at

12 What the procurer needs to decide Whether to purchase R&D services, or conduct a PCP? Would a PCP+PPI be profitable? How long do we have to implement the new technology before we break even? What royalty rate should we offer as a profit-sharing agreement?

13 Uncertainty and the PCP

14 Uncertainty Probabilities No future is certain Uncertainty can come from Technology unknowns costs, performance, reliability Market unknowns prices, economies of scale, openness We introduce probability to account for uncertainty Is always a factor between 0 (will never happen) and 1 (will always happen) 0 < q < 1 Values with uncertainty are expected, not real Every day I walk my dog in the morning. Twice a week, we see joggers. Throughout the entire week, you have a 29% (2 days / 7 days) chance of seeing joggers. q =.29

15 Justifying a 3-phase PCP - Overview The probability that the full R&D budget has to be paid even if the benefits don't occur is always lower in a PCP (3-phase vs 1-phase) Based on a market consultation, the procurer estimates the following probabilities of success at each phase: S1 q1 = 0,70 S2 q2= 0,75 S3 q3 =0,80 Project Phase Expense Probability Variable PCP phase 1 200, q1 PCP phase 2 300, q2 PCP phase 3 500, q3 Purchase 100, q=q1*q2*q3 Then the R&D success rate is q1*q2*q3 =,7*,75*,8=,42. Therefore q=0,42

16 Justifying a 3-phase PCP - Costs Costs for the public procurer in an all-in-one R&D services contract P with probability q C1 = with probability 1 q EC1= P q q EC1= The probability of complete loss is 1 q =1-,42=58% Costs for the public procurer in a PCP contract with 3 phases P with probability q C3 = with probability 1 q with probability q1 (1 q2) with probability q1 q2 q1 q2 q3 EC3 = P q q q1 1 q q1q2 q1q2q3 EC3 = The probability of complete loss is q1 q2 q1 q2 q3 =10,5%

17 Justifying a 3-phase PCP - Benefits Benefits for each are the same, where t is the number of months the solution is implemented t with probability q B = 0 with probability 1 q EB = tq q If the procurer estimates implementation of the resulting PPI over 48 months, then EB = , 42 = We can now calculate the Return on Investment (ROI) EB EC ROI = EC For the 3-phase PCP, the ROI is 37.4%, compared with the single stage of -4.2%

18 Time & Value

19 Time discounting For a more accurate estimates, we need to introduce time To do this, we use a discount factor δ, based on a discount rate i δ = 1 (1+i) t Every month t, the discount factor decreases The further in the future a cost or benefit is incurred, the less it affects our present value of the situation In our example, the procurer uses a financial interest rate of i=0,12% per month (1,44%/year) to calculate their discount factor Discounting choices The lower the discount rate, the greater value placed on the future e.g. social policy vs private investment in capital (7-12%)

20 Time Flowsheet for Valuing Future Costs and Benefits Months from Present Value Costs (R&D) 1,000, , ,000 Costs (Price) 100, Benefit (Savings - cost reduction) 2,425, Discount factor Present Value Costs (R&D discounted) 985, , ,779 Costs (Price discounted) 97, Benefit (Savings - cost reduction discounted) 2,290,

21 Calculating Net Present Value Present value the sum of discounted cash flows PV(Costs) and PV(Benefits) Since we are using expected (vs real) benefits and costs, we use PV(EC) and PV (EB) NPV = PV(EB) PV(EC) The procurer wants to know if the project is worth considering if its NPV is positive (>0) NPV = PV(EB) PV(EC) > 0 This is equivalent to the benefits being greater than the costs (hence, Cost-Benefit Analysis) PV(EB) > PV(EC)

22 Calculating Present Value of Expected Benefits Compared with costs, benefits are received over a number of months We need to add up the discounted expected benefits over each month PV B = PV EB B δ V1 + δ V1+1 + δ V1+2 δ V2 = V2 t=v1 B 1 + i t 0 with probability 1 q = q V2 t=v1 B 1 + i t with probability q Where B are the benefits, V1 is the first month that the solution is implemented, and V2 is the last In our example, the solution is implemented from month 24 until month 72 from the beginning of the PCP. The PV(EB) is therefore PV (EB) = 0,42 ( t=1-1+, t=1 ) 1+, = 0, =

23 Calculating Present Value of Expected Costs While the PV(EB) occur over a period of time, PV(EC) occur at discreet points in time We calculate PV(EB) by inputting values for costs of phase S (1, 2, and 3) month M (1, 2, and 3) when the phase ends probabilities of success (q1, q2, q3) at each phase PV(C) = s i M 1 s i M + s i M 2 s 1 with probability (1 q1) with probability q1 (1 q2) 1 + i M + s i M + s i M with probability (q1 q2) (q1 q2 q3) 3 s i M + s i M + s i M + P with probability q 3

24 Calculating Present Value of Expected Costs The PV(EC) is a long calculation: PV EC = , , , ,7 1,75 1 +, , , , , , ,0012 9, 7,75, 7,75, (,42) That is made easier by the use of Excel In our example, the PV(EC) of the PCP is

25 Net Present Value comparing PV(EC) and PV(EB) The procurer should invest in the PCP and PPI if the NPV is positive, that is, PV(EB) > PV(EC) q V2 t=v1 B 1 + i t > s 1 1+i M 1 1 q1 + s i M 1 + s i M 2 q1 1 q2 +( s i M + s i M + s i M ) q1 q2 q1 q2 q3 3 +( s i M 1 + s i M 2 + s i M 3 + P)(q)

26 Calculating break-even time Knowing the equation where PV(EB)>PV(EC), we can solve for different values that help us to better understand the potential project You can only solve for one unknown at a time This means choosing which value to find a minimum or maximum for, and making it the dependent variable. Your input values are the independent variables In this example, we will solve for the time it takes for the investment to break even - The number of months in the future where the costs=benefits Using the spreadsheet, we find that this is just over 39 months from project inception, equaling a minimum implementation time of 15 months. PV expected cash flows Costs PCP 722,092 Costs PPI 40,808 Benefits Savings 722,107 Net 15 Enter number of months in cell B83 that make cell B80 is just greater than 0. This is the break-even point in months from project inception t (number of months from beginning) 39.16

27 Calculating Return on Investment (ROI) The Return On Investment (ROI) expresses how many additional euros are generated by a single euro invested in the PCP project. If ROI > i then, from a purely financial point of view, investing the money in a PCP would be more profitable than in market activities. ROI = PV EB PV(EC) PV(EC) = NPV PV EC ROI = 941, = = 30,41%

28 IRR is this many times greater than market interest rate in cell B27 Calculating Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the minimum rate i needed to make the NPV positive Using Excel makes this task much simpler In this example, the IRR is 0,5172%/month, or 6,2%/year. Supports that PCP can be profitable even for costly R&D with uncertainties PV expected cash flows Costs PCP 690,650 Costs PPI 88,355 Benefits Savings 779,015 Net 10 Solving for IRR Enter the interest rate in cell B65 that makes cell B61 just greater than 0. This the interest rate that makes PV(EC)=PV(EB), and is equal to the Internal Rate of Return (IRR) Alternative interest rate (%)

29 The Stand-Alone PPI

30 Calculating NPV of only a Public Procurement of Innovation (PPI) A PPI is simpler to calculate, since there is much less uncertainty without R&D At this point, we assume the risk of failing to develop the product is eliminated Future benefits are no longer termed expected, but real The cost for the procurer in a PPI is the purchasing price Now, costs are given now only by the purchasing price, such that C = P. The present value (PV) of all future benefits would now be PV B = B δ t + δ t+1 + δ t+2 δ X = X t=1 B 1 + i t Where X is the last month in which the solution is implemented, B is the monthly benefit, and t is the month NPV = X t=1 B 1 + i t C

31 Calculating NPV of only a Public Procurement of Innovation (PPI) (cont.) The formula for NPV is given by NPV = X t=1 B 1 + i t Using the values from our example, with timespan of the PPI project t = X = 48, we get calculate the NPV of our project as NPV = , C t= = If we want to find the maximum price to pay for the product, we can set the NPV to 0 and solving for P instead of setting the price at P 48 t= , = Remember that this price is includes discounting. To bring it back to current euro, as what we would invest at the present time, we can use the PV function in excel. This is equal to

32 Sharing Profits: Royalty Schemes

33 Commercialization & production Vendor PCP PPI Market Profit (1-N)% Procurer N%

34 Reducing Costs of R&D Investments Procurers have two options to reduce the costs of their PCP investments Ex-ante: setting maximum costs and awarding based on submitted R&D prices Ex-post: creating profit sharing agreements as royalty schemes Intellectual Property Rights (IPR) can be generated during any PCP phase Not all suppliers who create IPR will Commercialize their solutions Win the PPI Generate profits in wider markets If the IPR is left with the supplier, a procurer pays pay for part of this IPR without being certain of receiving benefits from the investment

35 Profit Sharing Agreements Assumption: IPR stays with the supplier, grants free license; Supplier is responsible for commercializing PCP outcomes To capture benefits from IPR generated during the PCP, when IPR is left with the supplier, a procurer can use a profit sharing agreement. Procurer takes a % of profits (royalties) post-commercialization Agreements made prior to beginning each phase with each R&D supplier Procurer can benefit from their investment regardless of which supplier is dropped from the competition and when Two areas for the business case: For each PCP stage: Contributions of the procurer and supplier to R&D After the completion of the PCP: Break-even time

36 Minimum number of suppliers t o ensure compet it ion in PCP Budget per phase EUR EUR EUR Budget per supplier per phase EUR EUR EUR profit-sharing agreements 3 profit-sharing agreements 2 profit-sharing agreements

37 Choosing & Using Royalty Rates Royalties: a percentage of the profit based on investment in IPR Royalties should be taken only when the supplier begins to make a profit Which royalty rate the procurer should set for each supplier within each stage of a given PCP? G i,j - cost of PCP to the procurer in PCP phase i to supplier j H i,j - contribution of supplier j during PCP phase i N i,j - percent of profit (royalties) requested by per month from supplier j The royalty rate for supplier j who participates in PCP phase i is then N i,j = G i,j (G i,j + H i,j )

38 Calculating a Royalty Rate Example A procurer has a budget of 100,000 for phase 1, for four suppliers Each supplier receives 25,000 For supplier 1 we write G 1,1 = 25,000 Assume that this is 20% of the total R&D costs, so that contribution by each supplier in phase 1 will be 125,000 ( 25,000/.2) For supplier 1, we write H 1,1 = 125,000 This means that royalty rate for supplier number 1 for PCP phase 1 are N 1,1 = G 1,1 (G 1,1 +H 1,1 ) = 25,000 25, ,000 =.17 = 17%. Repeat for each phase and supplier

39 Calculating Royalty Rates for Each Supplier & Phase Example Royalty rate for supplier 1 would increase to 23% for IPR from phase 2, and to 29% for IPR from phase 3.

40 Calculating Break-even Time for Royalty Agreements After each phase of the PCP is complete, a royalty agreement can come into effect Now we are examining the situation after the completion of the PCP Costs are not R&D costs contributed by suppliers in the PCP, but all other costs: costs of commercialization, production, marketing, offices, staff Introducing p - probability of successful commercialization of any supplier involved at any stage of the PCP that includes any IPR generated under the PCP P i,j - monthly profit of supplier j who has successfully commercialized using IPR from PCP phase i P i,j = R i,j C i,j, (profits are revenues minus costs) Q i,j - total royalties received by the procurer by time t from supplier j based on their successful commercialization using IPR from PCP phase i

41 Calculating Break-even Time for Royalty Agreements Expected benefits to the procurer, given the probability of successful commercialization p For each supplier j at PCP phase i, the expected benefits EB i,j can be expressed as: PV EB i,j = Q i,j = p N i,j δ M i + δ M i+1 + δ M i+2 δ Y i,j = p N i,j M i - the first time t where R i,j > C i,j, R i,j C i,j 1 + r t Y i,j - the time t where Q i,j = G i,j (wheretotal royalties received from supplier j in PCP phase i are equal to the procurer s investment to supplier j in PCP phase i Y i,j t=m i when R i,j > C i,j 0 when R i,j C i,j

42 Calculating Break-even Time for Royalty Agreements Royalties are only at a given time t when R i,j > C i,j Break-even time for each investment C i,j to each is the point in time after which Q i,j = C i,j Present Value of total Expected Benefits PV EB = p Q i,j i, j Note: Procurers do not make a profit themselves Benefit from the results of the solution which followed the PCP in a successful PPI Stop at the break-even time

43 Calculating Break Even Time Example One supplier who reached the end of PCP phase 3 takes 6 months to commercialize the results of the IPR they generated Commercialization and production costs 450,000, with a 70% likelihood of success Firm operates at a loss for 8 months Profit begins from month 9, at 20,000 every month (for at least 40 months into the future)

44 Calculating Break Even Time Example Repeat for each phase completed by the supplier

45 Break Even Time Example

46 Summary

47 Summary - Uncertainty Uncertainty is introduced as a probability a factor between 0 and 1 that reflects the likelihood that something will occur Success of each PCP phase Successful commercialization Receiving expected market revenues More information = better estimates Importance of market consultation Due to uncertainty, a 3-phase PCP is always better than all in one stage Probability of complete loss is lower Return on Investment (ROI) is higher ROI = Benefits Costs Costs

48 Summary Time & Returns Valuing costs and benefits in the future is done by using a (carefully selected) discount rate Calculate cash flows over multiple months by using indefinite summation (Σ) Cash flows at one time are more suited to examining probability Measures of project profitability Net Present Value (NPV) to predict project profitability NPV = Present Value Expected Benefits Present Value (Expected Costs) Internal Rate of Return (IRR) rate of return from an investment Alternative discount rate i that makes the NPV=0 Return on Investment (ROI) investment gains compared with investmetn costs Benefits Costs ROI = Costs

49 Summary Finding Max s & Min s Once you have the basic formula NPV = Present Value Expected Benefits Present Value (Expected Costs) You can calculate maximum/minimums for any value by finding what makes Benefits = Costs 1. Choose one variable to be dependent 2. Set values for the other independent variables 3. Solve using a program like Excel This can tell the procurer The minimum time over which they should implement a PPI solution Minimum success probabilities, minimum R&D revenues, etc. etc. We solved for the break-even time t

50 Summary Profit Sharing Profit sharing can make PCP a more attractive investment for procurers Helps compensate for high up-front costs A procurer can calculate revenue sharing based on predictions of wider market revenues Influence of commercialization risk / probability of commercial success Investment risk and potential rewards (royalties) are spread over suppliers and phases

51 Summary Introduction to procurement economics Innovation procurement Pre-commercial Procurement (PCP) Public Procurement of Innovative Solutions (PPI) Introduction to the Business Case Methodology Economic evaluation theory and practice Uncertainty - Justifying PCP Time - Discounting, Net Present Value, Returns The stand-alone PPI Reaping rewards Royalty Schemes Discussion

52 Thank you!

53 Discussion

54 Annex

55 PCP vs PPI PCP PPI When Challenges requires R&D No commitment to PPI Challenge requires (near-to-market) solution; No R&D What How Purchase of R&D to steer development, inform alternatives, & avoid lock-in Purchase of R&D from several suppliers in parallel Procurer is launching customer / early adopter / first buyer Buy critical mass of innovative solutions to trigger industry